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The following is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trade options almost exclusively, and enjoys sharing his experiences with anyone who is interested.

One Winged Butterfly Flying in a Turbulent Market

Butterflies are such a low income options strategy that they make little sense to the average trader. The commissions they eat up hardly pay for the gains on a small number of contracts. But, there is a less conventional way of opening a butterfly that solves some of the dilemma.

Using calls, or puts for that matter, it is possible to create a synthetic sort of butterfly, one that has only one wing, and uses two different underlying instruments; in this case two ETFs, one of them triple leveraged. One example would be FAS and XLF, both currently trading at similar prices, but with one slightly higher than the other.

The key is determining what point the prices would theoretically become identical. With XLF trading near the $12.00 mark and FAS trading closer to $11.25, if prices rise, the triple leverage on FAS will eventually result in an increase in price that outweighs the current disparity. It is sort of like the old physics experiment where a student is attempting to fill a bucket that has a small hole in the bottom. At some point, if water is added quickly enough the bucket will start to fill up. The actual equation could be quite complicated and involves a bit of Calculus, but a fair approximation would be that the point where these two ETFs start too fill the bucket would be near $12.40.

There are occasions when it is possible to sell naked calls on XLF and buy calls on FAS for equal premiums; sort of like creating a net-even butterfly. Choosing a strike price as close to the point of collision as possible yields a payout diagram with a very small body; a missing left wing; and a right wing with unlimited upside. Perhaps it’s not the sort of thing for everyday trading, but when the winds of change are pushing the Dow up and down hundreds of points weekly, sometimes daily, this butterfly usually soars out of sight or lands harmlessly.

Of course, it is possible to just use a ratio spread on one ETF or the other and accomplish a similar outcome. However, this strange looking butterfly has a curved wing on one side. The curve is due to the additional compounding effect that the triple leveraged ETF has over the other one, an added benefit that is not possible with a traditional ratio spread.